Stock Trading Basics
Hedging the Risk in a Stock Portfolio Using Options
By Frank Kneipher
May 20, 2007 - 5:50:46 PM

Hedging the Risk in a Stock Portfolio Using Options

Option buying can be a useful strategy for investors/ traders of all types. When buying options, one’s risk is known in advance, and the trader or investor can tailor the quantity of options to be in line with his appetite for risk.

With a potential market downturn, we are going to look at put option buying as a strategy that might be employed. Put options increase in value as the underlying — stock, index, or ETF — declines in price. Keep in mind that the buying of a put option is a bearish strategy for speculators, or a hedge against price declines if bought as a hedge against a portfolio of stocks.

Technically, a put option gives the owner the right to sell the underlying at a predetermined price (the strike price of the option) — but to take advantage of that right, one would have to exercise the put option. Most people never get involved with exercising the option, so it is really much simpler to just understand that the put option increases in value as the underlying instrument’s price declines.

Every option has a strike price and an expiration date. If the underlying is above the striking price of a put option on the expiration date, the option will expire worthless. However, if the underlying is

below the striking price on the expiration date, then the put option will have value, equal to the difference between the striking price and the underlying price.   Expiration dates for listed options are always the third Friday of the month. So, it is only necessary to specify the month (and year) of expiration. Typically, there might be 5 or 6 expiration dates in existence at any one time.  In addition, many stocks and ETFs have longer-term options as well, and those usually expire in January, so there might also be options expiring in January of 2008 and January of 2009.   These longer-term options are called LEAPS options, but they work exactly like any other option — they just have the longer-term expiration date.

No matter what happens, you can’t lose more than you initially paid for the put option. However, you can lose all that you paid for it — 100% of your investment.   Intelligent option traders only risk a small, fixed percentage of their trading account on the purchase of any one position. You can tailor your risk and your reward by your selection of the expiration date and the striking price.